All Commentary
Wednesday, January 4, 2012

The Euro: The Folly of Political Currency

The financial markets continue to surge and collapse based on the latest news from Europe. As of this writing, the big events are Slovakia’s unwillingness to contribute to a bailout fund and the failure of Dexia, a French-Belgian bank with assets of almost $700 billion. As the sovereign debt crisis has intensified in the last few months, it is becoming a real possibility that the euro itself will soon collapse.

Even if it managed to squeak through and survive—aided by massive taxpayer infusions along the way—the euro’s vulnerability underscores the folly of a political currency. More so than any other currency in history, the euro has been a creation of technocrats working for modern nation-states. That the euro may well be on its deathbed hardly a decade after its birth demonstrates the futility of central planning. A durable monetary system, free from recurring crises, can only emerge spontaneously from voluntary exchanges in the marketplace.

The European Union and euro were officially created by the Maastricht Treaty in 1993. In addition to the political and cultural objectives, the EU and the single currency, which went into circulation in 2002, were significant steps in the effort to turn Europe into a unified economic zone patterned after the United States.

Before the introduction of the euro, a large business based in France that, say, had a factory paying workers in Italy and which bought machine parts from Germany would be vulnerable to shifts in the exchange rate between the franc, lira, and mark. But with a single currency the firm could focus on its customers and product lines, rather than worrying about the foreign-exchange market. This stability across the continent would (supposedly) give European businesses the same advantages that U.S.-based firms enjoy, since Americans in all 50 states use the dollar.

Because a currency’s ability to facilitate transactions only increases as more people use it, at first we might expect that the nations adopting the euro would want as many of their neighbors as possible to join. Yet in reality there were formal rules (called the Maastricht criteria, also the “convergence criteria”) that new applicants needed to satisfy before adopting the euro. The rules set standards for countries’ inflation rates, budget deficits, government debt, exchange rates, and long-term interest rates.

At first glance it seems odd that the developers of a new currency would want to restrict its usage. To repeat, the whole point of a currency union is to reduce transaction costs among the individuals using it. Thus it would seem that these benefits would only increase as the group grew.

Yet there are other factors at work, which the designers of the euro understood (if only imperfectly). In particular the euro is a fiat currency, meaning that the printing press could be used to achieve political ends. This explains why governments already using the euro are reluctant to admit relatively spendthrift governments into their club: There is a danger that the more profligate members will hijack monetary policy directly, or that they will require a monetary bailout (as we are seeing in practice).

Benefits of a Commodity Standard

Notice that these potential problems would be nonexistent under a fully backed commodity standard. For example, suppose that the creators of the euro, rather than reading the work of mainstream monetary theorists such as Robert Mundell, instead had studied the proposals of Ludwig von Mises in The Theory of Money and Credit. In this alternate universe the authorities in Brussels would stand prepared to issue new paper euros to any individual or institution (including governments and central banks) that handed them a fixed weight of gold.

Under this Misesian scheme the monetary authorities would maintain 100 percent gold backing of the currency; there would be the required weight of actual gold sitting in the vaults in Brussels backing up every paper euro in existence. In this scenario the authorities in Brussels wouldn’t care about the creditworthiness or the spending habits of the institutions applying for new euros. So long as the applicants handed over the correct amount of physical gold, the authorities would be happy to print up the appropriate number of euros.

The reason for this nonchalance is that the various users of the euro—if it were backed 100 percent by gold—couldn’t affect the euro’s purchasing power because they couldn’t affect future “monetary policy” regarding the currency. If the people in Region A used the euro, they wouldn’t be affected by (say) a default on bond payments by some government in Region B that also used the euro. The euros in existence, as well as the ones to be issued in the future, would have a constant redemption rate in gold, regardless of the fiscal solvency of a particular user of the euro.

In case the Misesian thought experiment is too fanciful, we have a much more pedestrian (if imperfect) example: U.S. state governments and their use of the dollar. If the California or Illinois state governments default on the billions of dollars in outstanding bonds that they have issued, no one is worried that this will lead to a collapse of the dollar itself, or that the relatively frugal states (such as Idaho) will elect to leave the “dollarzone” and adopt their own currency.

Thinking through the logic of the situation, it becomes clear that the reason for the difference is that the Federal Reserve (at least in the past) wouldn’t bail out insolvent state governments. To be clear, the people in Idaho might be affected by a default on California state bonds, but not because both areas used dollars as their currency.

However, if the Fed did start bailing out insolvent state governments, then the various states in the “dollarzone” might sit up and take notice. People in Idaho would realize they were paying higher prices because the Fed was creating billions of new dollars out of thin air to prop up the market for state bonds. In this environment a coalition of frugal state governments might demand that their profligate peers adopt austerity measures or else the frugal states would indeed abandon use of the dollar.

As this thought experiment illustrates, we can imagine a situation analogous to the crisis in Europe right here in the United States. All it would take is a Federal Reserve willing to issue extra dollars because member governments ran irresponsible fiscal deficits. We don’t currently link state government finances and the fate of the dollar because the Fed thus far hasn’t altered its policies based on state spending. Under a fully backed commodity standard, this independence of monetary and fiscal policies would be more absolute and would have prevented a crisis like the one now unfolding in Europe.

Those who have followed the mainstream economists’ handling of these issues know that gold convertibility is hardly touted as a solution to the euro crisis. In fact Paul Krugman recently blamed the crisis on the attempts to foist a “nouveau gold-standard regime” on European countries.

This is quite an extraordinary spin. How in the world could Krugman take a fiat currency, explicitly designed from day one by technocrats and without even a historical connection to a commodity money, and denounce it as a modern-day gold standard?

The answer is that Krugman is relying on the mainstream theory of optimal currency area. This theory tries to outline the optimal jurisdictions for different fiat currencies. In this approach the downside of having too large a region using the same currency is that the “optimal” amount of inflation might differ within the region, leading to unnecessary economic pain and hence political conflict.

In the present crisis Krugman and many others think the “obvious” solution would be for Greece to devalue its currency. This would make it easier to repay its debts and would make Greek exports more competitive, thus boosting economic growth.

Alas the problem (according to people like Krugman) is that Greece is not the master of its own economic destiny. Since it adopted the euro it is now powerless to inflate its way out of trouble. Thus the Greeks are condemned to suffer from fiscal austerity and a painful deflation of wages and prices (also known by the misleading term “internal devaluation”).

Now we can understand the (tepid) connection that Krugman and others are drawing between the current situation in Europe and the classical gold standard. Under the latter, if one country printed too much money its domestic prices would rise faster than those of its peers. The country would experience a trade deficit as its own exports became relatively expensive. The outflow of gold from the country would force officials to tighten monetary policy until wages and prices had fallen (if not in absolute terms, at least relative to the levels of other nations) and international competitiveness had been restored. Under the classical gold standard each nation’s currency was pegged at a fixed exchange rate to gold, so that no country could gain an advantage by devaluing its own currency. All adjustments to ensure sustainable trading patterns had to occur through changes in relative prices and wages, not through fluctuations in exchange rates.

Further Integration

The mainstream theory of optimal currency area sheds light on another (alleged) lesson being drawn from the present crisis: the need for fiscal union among the eurozone states. For example, Mario Draghi, the incoming head of the European Central Bank, recently said Europe needs to “make a quantum step up in economic and political integration.” Mainstream theory shows that it is suboptimal to have a single currency covering areas with governments enacting different fiscal policies, and hence the “obvious” conclusion is that the European governments must be brought under the control of a single agency.

As usual one intervention leads to another. After historically co-opting and then suppressing the market-chosen monies (gold and silver), the European governments in recent years upped the ante by creating a new fiat currency. Even though the ostensible safeguards failed miserably—Greece and several other participating governments have come nowhere near obeying the Maastricht criteria—the alleged solution is the creation of even more centralized power, with even less control by the people being so ruled.

The people of Europe are being conned. They do not need to sacrifice even more political sovereignty to a group of international bureaucrats and bankers. The dream of the euro—an integrated economic zone with a stable currency—can be achieved through the classical-liberal tenets of free trade and sound money. Continued experiments with fiat money regimes will lead us through a perpetual series of crises, until we are left with a single global fiat currency, the issuer of which has zero accountability to the hapless citizens forced to use it. According to many cynical observers, this after all may be the ultimate plan.

  • Robert P. Murphy is senior economist at the Independent Energy Institute, a research assistant professor with the Free Market Institute at Texas Tech University, and a Research Fellow at the Independent Institute.